Consumer Law

Fed's Mortgage Regulations

By Alan White

By Alan White

Greetings from ORD! Yes, I'm on American, trying to get to Dallas. TV cameras are everywhere, and I have a bit of time on my hands. HT to the Trib for the photo of our rebooking line.

The comment period for the Fed's proposed regulation on unfair and deceptive practices in the mortgage market closed on Tuesday. So far 1,062 comments are logged, and there are more coming (including mine.) Congress is unlikely to move mortgage reform legislation in this election year, particularly legislation that the President would sign. The Fed's new rules, due to be finalized some time this year, will be the first serious effort to impose some order in the lately deregulated mortgage market. How much of the problem will they solve?

The fundamental problem with subprime mortgage lending was that the industry substituted dangerous and inappropriate credit products for the safe, reliable, home affordability product known as the 30-year plain vanilla mortgage. The beauty of the traditional conforming mortgage (created by HOLC and FHA, not the free market, in the 1930s) was that it replaced the interest-only balloon mortgages of the 1920s with a product that allowed home buyers to pay a fixed, affordable monthly payment and eventually pay the loan principal in full, without the need to refinance or sell at the end of the term. FHA allowed the standard 20% down payment to be reduced to as little as 3%, but still required verified income, reasonable debt ratios, and an equity stake.

The subprime industry set about selling Americans on the idea of getting a larger loan with a lower monthly payment. They did this with a variety of "innovations", many of which reverted to loan structures used before the Depression. An interest-only loan, a balloon payment loan or a loan requiring payment of less than the interest (negative amortizing option ARMs) can produce a lower payment, in the short run. So can a teaser-rate ARM, where the initial rate, for the first two or three years, is not the fully-indexed interest the consumer will have to pay over the life of the loan. Another trick was to dispense with the monthly payment for taxes and insurance (escrow). Subprime lenders also decided to permit borrowers to exceed the standard 35% to 41% debt to income ratios considered prudent maxima by conventional and FHA lenders, based on decades of experience. Instead, subprime borrowers could pay 50%, 55% or even 60% of gross income for their mortgages. Finally, if that didn't make the loan "affordable", subprime lenders allowed income to be fudged, or simply invented, by promoting no-doc and stated income loans.

The Fed's proposed rule deals with some of these issues. It sensibly mandates that subprime mortgages come with monthly escrow for taxes and insurance, perhaps its least controversial element. It also effectively prohibits no-doc loans, requiring reasonable documentation of income. The rule would require a reasonable determination of repayment ability, without setting debt ratios or other absolute underwriting rules. On the other hand, it insulates lenders from liability for making unaffordable loans unless a "pattern or practice" is proven. The rule also tries to get at broker fee practices, recognizing that existing incentives encouraged brokers to steer borrowers to larger, riskier and inappropriate mortgages.

The proposed rule misses an opportunity to deal with an important problem in the subprime market: prepayment penalties. These are rarely imposed in the prime market and prohibited for FHA and VA mortgages. Prepayment penalties trap borrowers in high-rate loans, which is good for the investors in the junk-bond tranches, who trap a little more yield, but very bad for the borrowers. Roughly one-third of subprime borrowers who got a loan with a prepayment penalty ended up paying the penalty, which is typically about 4% of the loan. In return, they may have saved 0.2% on their interest rate, according to empricial studies. The proposed rule restricts prepayment penalties, by requiring that they expire before a rate reset, but continues to allow their use.

What the rule does not do is to restore the fully-amortizing level payment mortgage to its primary role as a home financing tool for low- and moderate-income Americans. Nor will the market achieve this left to its own devices. Subprime rate sheets for current (March 2008) offerings still feature teaser-rate ARMs, albeit with a 5-year initial low payment period instead of two or three years. No-docs are still available. The best that can be hoped is that by imposing some restrictions on risky subprime loans, the rule will allow FHA and safer subprime products to compete more effectively for home buyers' and borrowers' attention, reducing the future subprime market to a suitably marginal role in home finance and consumer credit.

Full post as published by CL&P Blog on April 10, 2008 (boomark / email).